Lumentum Has Appeal Beyond the iPhone

Lumentum (ticker: LITE) stock is down 12% over the past five trading days (versus Nasdaq Composite down 1%) primarily on noise related to new [
Apple
(AAPL)] iPhone consumer demand and supply-chain orders.

However, our checks tell us that Lumentum’s vertical-cavity surface-emitting laser (VCSEL) orders and yields have steadily improved in recent weeks. We believe orders have increased from about $200 million to about $300 million during August and September, and we think the company is now on track to deliver over $200 million of 3D Sensing VCSEL array revenues in second-half calendar 2017. We are also picking up on some slightly improving vendor-managed inventory (VMI) pulls for Optical products in China, and we expect Chinese Optical demand to meaningfully positively inflect in calendar 2018.

We are confident Lumentum’s 3D Sensing orders have significantly increased since the company’s Aug. 9 earnings, despite all of the noise in the trade press about possible iPhone supply chain order reductions. The company’s VCSEL orders have increased because its competitors have seen qualification and/or yield delays, so Lumentum currently has 100% market share. We believe Apple plans to produce 100 million iPhone Xs in the first 12 months. Each iPhone X likely has over $4 of VCSEL content. Apple probably needs a little more VCSEL arrays than this math implies to account for completed 3D module yields that are high but still less than 100%.

Lumentum is the only optical-components company with a clear path to a near-term beat and raise. Our fiscal first- and second-quarter revenue estimates are in line with consensus, and we are modeling only $44 million in 3D revenue in September and $125 million in December. We are not changing estimates at this time, but we think it is very likely Lumentum will deliver at least $200 million in second-half calendar 2017. In our view, Lumentum is the only name in the optical-components sector that should clearly beat-and-raise in the near term, likely driven by 3D sensing upside. Looking ahead to first-half calendar 2018, we expect another very strong 3D quarter in March. Apple demand will likely seasonally moderate in the June quarter, but we think Lumentum should have at least two other meaningful 3D customers starting to contribute in the fiscal fourth quarter (ending June).

According to our checks, Lumentum is starting to see some slightly better VMI pulls in China for CFP2 Datacom modules. We think optical orders from China will more significantly improve, and for more products, in first-half calendar 2018. Lumentum’s Chinese OEM customers have healthy businesses, both in China and abroad. The issue is that they have been living off of optical-component inventory since April. While it is unclear exactly how much inventory remains, and the exact date that better orders will begin, we think it is very likely that better orders will start in the next one to three quarters. We view new tenders and projects as important drivers in calendar 2018, but we think inventory normalization is the #1 factor that will lead to Chinese demand recovery for the optical-component names.

Our 12-month price target of $66 is based on 13 times potential fiscal 2019 earnings per share of $4.80 plus $4 per share net cash. The potential fiscal 2019 EPS are composed of $1.80 from optical/lasers and $3.00 from 3D. The $3.00 of 3D earnings power is based on a fiscal 2019 total available market (TAM) of $1.5 billion and a 45% market-share assumption, or $675 million in fiscal 2019 3D sales versus the $410 million in our model.

-- Michael Genovese

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